Words from the (investment) wise for the week that was (November 17 – 23, 2008)

A new bout of fear gripped financial markets during the past week, causing the slide in global stocks, commodities and emerging-market assets to deepen. As investors’ angst escalated, positions in risky assets were liquidated in exchange for perceived safe havens such as the US dollar, government bonds and gold bullion.

“We have seen fundamental selling, technical selling, forced selling (deleveraging), short selling, capitulation selling and selling due to ennui,” commented David Fuller (Fullermoney).

Fueling the sell-off were mounting concerns that the economic recession could not only be more intense than previously feared, but also fall into a corrosive deflationary phase. Additionally, sentiment was undermined by renewed questions about the effectiveness of the US government’s bailout plans.

A clear sign of distress and fear was the US three-month Treasury Bill rate falling to zero on Thursday, before nudging up to (a still minuscule) 0.10% by the close of the week. “The financial situation at the moment is so bad that women are now marrying for love,” quipped an e-mail doing the rounds.

After the S&P 500 Index breached the grim milestone of the October 2002 lows and fell to levels last seen in 1997 – thereby threatening to wipe out the entire 2002 to 2007 bull market – Wall Street regained some confidence late on Friday. The trigger for a strong turnaround arrived just in time for the 15:00 ET witching hour and came in the form of Timothy Geithner’s (pronounced GYTE-ner) nomination as new Treasury Secretary, resulting in the S&P 500 recovering from an intraday loss of more than 1% to a gain for the day of 6.3%.

On the bailout front, the Detroit automakers sought $25 billion from the Treasury to avert bankruptcy. However, Congress withheld financial aid for the time being, giving the companies until December 2 to submit a “viable” recovery plan.

“Don’t be misled, though – the something that is rotten in the auto industry has nothing to do with the credit crunch, and everything to do with years of mismanagement, shoddy products and bad choices,” said Bloomberg columnist Mark Gilbert. “Consider the credit-rating histories of GM and Ford. For both companies, the rot started all the way back in August 2001, when Standard & Poor’s put the A grades they enjoyed for a decade on review for downgrade. In October of that year they each suffered a two-level cut to BBB+ that left them just three moves away from junk status.”

I received the following note from an American friend a few days ago: “…even the children in my son’s second grade class are depressed about the auto industry. I had to answer my son’s questions about bankruptcy since the kids are talking about it …” This comment says it all!

Elsewhere, Citigroup’s (C) share price plunged by 60.4% over the week to a 16-year low as the company wrestled the financial crisis and planned to slash 50,000 jobs. According to The Wall Street Journal, “Citigroup officials have been talking in recent days to Treasury Department and Federal Reserve officials, and those discussions are expected to continue throughout the weekend …”

A pointed comment regarding the principle of bailouts came from Jim Rogers, as quoted by the Financial Times: “What they’re doing is taking the assets away from the competent people, giving them to the incompetent people and saying to the incompetent: ‘Okay, now you can compete with the competent people, with their money.’ I mean this is terrible economics. This is outrageous economics.”

Next, a tag cloud of the text of the plethora of articles I have read since a week ago. This is a way of visualizing word frequencies at a glance. Keywords such as “banks”, “economy”, “market” and “prices” occur often, but words such as “gold” and “deflation” have also started creeping into the tag picture.

The following update on the stock market outlook arrived on Friday from Bennet Sedacca (Atlantic Advisors): “We have been barely invested, mostly void, in equities, since May. We went ½ long today near the lows for a rally that could last longer than some think. Mostly large cap, high-quality, excellent balance sheet companies with a little tech and financials thrown in. We must remember, buy when you can, not when you have to.”

Oversold conditions are bound to result in rallies from time to time (and possibly around Thanksgiving), but these should not be trusted at face value. For a more lasting market turnaround to happen, I would like to see evidence of base formations on the charts, a 90% up-day, and relative outperformance by the financial sector.

I am also closely monitoring the surges in the US dollar and Japanese yen – low-yielding currencies previously used for funding risky investments – as a break of the uptrends in these two currencies will be a good indicator of the forced deleveraging selling starting to subside. Once this situation has played itself out, we should see a return to lower volatility levels and a return of confidence. (Also read my recent posts “Economic woes torpedo stock markets” and “Panic-crash sentiment causes extreme volatility“.)

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economic reports
The Ifo World Economic Climate has worsened further in the fourth quarter of 2008 with the indicator falling to its lowest level in more than 20 years, according to the Ifo World Economic Survey. Not only the major economic regions of North America, Western Europe and Asia are affected, but also Central and Eastern Europe, Russia, Latin America and Australia. On the whole, the survey data point to a global recession.

Economic reports released in the US during the past week confirmed an increasingly dire situation.

• The US moved closer to deflation territory as the CPI decreased by 1.0% from September to October (the largest monthly decline since the 1930s), leaving the CPI 3.7% higher compared with a year ago and significantly down from September’s 4.9% rate. The continuing decline in US economic activity is pushing down inflationary pressure.

• Because of weak demand, producer prices for finished goods gave up ground for the third month in a row, falling by 2.8% in October largely as a result of much less expensive energy products.

• On par with expectations, residential construction slowed again in October, with a 4.5% month-on-month decline in total housing starts. At 791,000 annualized units, starts have hit another record low as exceptionally weak demand was constraining homebuilding.

• The NAHB housing market index fell further in November, setting a record low.

• Slumping demand is hitting US industry hard, although production bounced back in October from hurricane-related declines in September. Total industrial production increased by 1.3% after having fallen a downwardly revised 3.7% in September, but the indicator fell around two-thirds of a percent in September and October when excluding once-off effects.

• Initial claims for unemployment insurance benefits increased by 27,000 to 542,000 for the week ended November 15, putting claims at their highest point since the early 1990s. This is a serious warning signal about the health of the labor market.

• The Conference Board Index of Leading Economic Indicators declined by 0.9% in October, led by a sharp plunge in stock prices and decreases in residential building permits and consumer expectations. The LEI in the last three months has shown an acceleration in the rate of decline, adding to evidence that the US has entered a recession that will likely be much deeper than either of the previous two.

It comes as no surprise that the minutes of the Federal Open Market Committee’s meeting of October 28 to 29 indicate that members were extremely concerned about the near-term prospects for the economy, given the stresses in financial markets. With the problems in credit markets persisting, the FOMC’s forecast called for falling growth through the first half of 2009, with next year’s real GDP growth projection lowered to -0.2% to 1.1% (previously 2.0% to 2.8%).

Banks continue to hoard all the liquidity the Fed is injecting directly instead of lending it out. This raises the question: Is the Fed “pushing on a string”? Asha Bangalore (Northern Trust) commented as follows: “The lowering of the Fed funds rate, the Fed’s innovative programs to provide liquidity to financial institutions and more lenient rules for borrowing through the discount window appear to have exhausted the gamut of possibilities routed through monetary policy changes to influence aggregate demand.

“The provisions of the Emergency Economic Stabilization Act of 2008 allow for recapitalization of banks. The FDIC is working on obtaining an approval for the anti-foreclosure plan to address the housing market issues that are central to the current crisis. … the probability of a hefty fiscal stimulus package … is growing every day.”

Economic reports in other parts of the world were equally dismal.

Japan entered into its first recession in seven years as the financial crisis curbed demand for its exports. GDP growth contracted by 0.1% during the third quarter, or at an annualized rate of -0.4%, following a second quarter contraction of a massive 0.9%.

China also warned that the unemployment outlook was “grim” as a result of the financial crisis forcing the closure of more export-oriented factories.

In Europe, a further slowdown in economic activity caused the Swiss National Bank to announce a surprise 100 basis-point cut in its three-month target range to 0.5%-1.5% – the third emergency reduction in two months.

Next week’s US economic highlights, courtesy of Northern Trust, include the following:

1. Existing Home Sales (November 24):Sales of existing homes are predicted to have declined in October after a small gain in September. Sales of existing homes advanced by 7.8% from a year ago in September, after posting declines since late 2005. Consensus:5.00 million versus 5.18 million in September.

2. Real GDP (November 25): Incoming economic reports suggest a small downward revision of real GDP in the third quarter to a 0.5% drop from the advance estimate of a 0.3% decline. Consensus: -0.5%

3. New Home Sales (November 26):Sales of new homes are expected to have fallen in October after a 2.3% increase in September. Sales of new homes have dropped by 32.1% from a year ago in September. Consensus:450,000 versus 464,000 in September.

4. Durable Goods Orders (November 26):Durable goods orders (-2.0%) are predicted to have dropped in October reflecting declines in bookings of defense and aircraft, which posted large gains in September. Consensus: -2.6% versus +0.9% in September.

5. Personal Income and Spending (November 26):The earnings and payroll numbers for October indicate a steady reading for personal income in October. Auto sales fell sharply in October and non-auto retail sales were noticeably weak, pointing to a likely drop in consumer spending (-0.6%). Consensus:Personal income +0.1%, consumer spending -0.9%

Equities
Global stock markets suffered badly during the past week on mounting worries about the severity of the economic slowdown. The week’s movements – MSCI World Index -9.6% and MSCI Emerging Markets Index -11.8% – tell the story of a rough ride for bourses all over the world and marked a third straight week of losses. And the scoreboard would have been even worse if not for a dramatic late-session recovery in the US on the news that Timothy Geithner would be named Treasury Secretary.

Not a single developed market closed the week unscathed. Similarly, large losses also abounded among emerging markets, with the sole exception being the Shanghai Stock Exchange Composite Index that recorded only a relatively small 0.9% decline. The Index plunged by 72.0% since its high of October 16, 2007 until hitting a low on November 4, but has subsequently bounced by 15.4% to flirt with its 50-day moving average and roundophobia 2000 level. Will the upside leadership for global stock markets come from China on this occasion?

The chart below shows the performances of the four BRIC countries during the past week.

Click here or on the thumbnail below for a (very red) market map, obtained from Finviz, providing a quick overview of last week’s performances of global stock markets (as reflected by the movements of ADR stocks).

The S&P 500 closed below its October 2002 low of 777 on Thursday, but Friday’s rally (+6.3%) to 800 put it back above this key support level. The Dow remained above its 2002 low of 7,286 on Thursday and closed 760 points above this level after Friday’s surge.

Click here or on the thumbnail below for a market map, also from Finviz.com, showing the performances of the various segments of the S&P 500 over the week.

As far as industry groups are concerned, gold (+19%) was the top performer for the week, led by Newmont Mining (NEM) on the back of a sharp rise in the price of gold bullion.

On the other side of the performance spectrum, the industrial real estate investment trust (REIT) group (-40%) was the worst performer. The diversified financial services group (-38%) was the second worst performer, with each of the group’s large banks – Citigroup (C), JPMorgan Chase (JPM) and Bank of America (BAC) – dropping sharply. Investor concerns about future credit losses, valuations of “toxic” securities on the banks’ books, job layoffs and capital adequacy issues were the drivers for the declines.

David Fuller (Fullermoney) commented as follows on the outlook for stock markets: “… we have yet to see evidence of bottoming out on many major stock market charts. While this is worrying, to put it mildly, and sentiment is diabolical, investors should recall an extremely important behavioural conditioning process. The crowd has always turned progressively more bearish with each additional decline towards the eventual low for every bear market. This is inevitable as more people sell, and unfortunately, few are more bearish than a battered holdout who finally capitulates.

“If global stock markets are not close to a major buying opportunity, then I suggest we should all head to sea and become Somali pirates.”

Fixed-interest instruments
Government bond yields across the world plunged last week as spooked investors rushed out of equities into sovereign debt.

The ten-year US Treasury Note yield declined by a massive 57 basis points to 3.18%, the UK ten-year Gilt yield dropped by 20 basis points to 3.87% and the German ten-year Bund yield fell by 30 basis points to 3.38%. However, emerging-market bonds, in general, lost ground as further deleveraging took its toll on risky assets.

The yield on ten-year Treasuries touched a 5½-year low (3.01%) on Thursday before rebounding by the close of the week, whereas the yield on 30-year bonds dropped to its lowest level (3.53%) since the start of regular issuance in 1977 before snapping back by 14 basis points.

US mortgage rates also declined, with the 30-year fixed rate dropping by 9 basis points to 6.09% and the 5-year ARM also by 9 basis points to 5.89%.

A number of indicators show that the credit crisis is still severe. For example, credit default swaps that measure default risk for investment grade debt are trading at their highest levels of the bear market. This is seen from Bespoke‘s index that measures default risk for 125 companies with investment grade debt ratings.

Currencies
The week’s feature among currencies was safe-haven flows into the US dollar and Japanese yen as investors liquidated risky assets previously funded with these low-yielding currencies.

The Swiss franc came under pressure as the Swiss National Bank slashed interest rates a full percentage point to 1% as an emergency step to soften the economic slowdown.

The chart below illustrates the accent of the US dollar and Japanese yen since September 15. (The US dollar is measured against a trade-weighted basket of currencies, whereas all the other currencies are measured against the US dollar.)

Emerging-market currencies had another bad week as a result of increasing risk aversion. Examples of losses against the greenback include the Brazilian real (‑10.4%), the Turkish lira (-4.5%), the South Korean won (-6.7%) and the South African rand (-4.4%).

RGE Monitor raised the question whether Bulgaria and the Baltic states will be forced to reset their fixed exchange rate pegs to the euro as a result of their large external imbalances and the global financial crisis. “Because of their fixed exchange rates, these economies cannot conduct independent monetary policy so the burden of macro-economic adjustment falls on fiscal policy.”

Commodities
The Reuters/Jeffries CRB Index (-6.5%) witnessed a further decline amid fears of a protracted global economic recession and expectations that demand will drop.

Gold bullion (+6.6%) bucked the trend and surged as the yellow metal found support among nervous investors as a safe store of value. A report that China might embark on a gold-buying program provided an additional boost.

On the other hand, West Texas Intermediate crude declined by a further 13.3% to $49.9 – a level not seen since May 2005. OPEC meets on November 29 to consider additional production cuts.

The graph below shows the movements of various commodities over the past week – a continuation of the intense bear market that has been in force since the beginning of July.

Lau-Tzu said: “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” Wise words indeed, but hopefully the news items and words from the investment wise below will cast some light on the lie of the investment land. And may the markets bring you additional reason to celebrate a joyous Thanksgiving.

Barry Ritholtz (The Big Picture): Record-breaking data everywhere!
“One of the interesting aspects of this unprecedented housing collapse, credit crisis, economic recession and market crash has been all the new records we keep seeing:

• Over the past year, the S&P 500 Index lost ~$1 trillion more than the entire 2000-2002 bear market, according to Standard & Poor’s. From the October 2007 highs of 1,565, to yesterday’s close of 806.58, the S&P 500 market capitalization lost $6.69 trillion. That’s almost $1 trillion more than entire 2000-03 bear market losses of $5.76 trillion. (Marketwatch)

• The S&P 500 hasn’t been this far below its 200-day moving average on a percentage basis since the Great Depression. (Doug Kass)

• CPI: US consumer prices in October registered their largest single-month decline since before World War II. It is the largest monthly drop in the 61-year history of the data;

• PPI, down 2.8% for the month, was also a record-breaking drop.

• The dividend yield on the S&P 500 is now greater than the yield on the 10-year Treasury. That hasn’t happened since 1958. (Barron’s)

• First-time claims for US unemployment insurance rose to the highest level since September 2001. The total number of people on unemployment benefit rolls jumped to the highest level since 1983.

• Housing starts fell to 791,000, off 38% from a year ago. That’s the slowest pace of starts since data began being compiled in 1959. Starts are now down 65% from the early 2006 peak – this has become the very worst housing downturn on record.

• Permits for new houses, at a 708,000 pace, were off 40% from a year ago, also the lowest total since it has been tracked starting in 1960. Put this into context of population – in 1960, the total US population stood at 180 million – 60% of today’s 300 million.

• The 30-year return for BBB-rated corporate bonds is now greater than the 30-year return for stocks. So it has not paid to take equity risk for 30 years! (The Street.com)

• The Russell 3,000 now has 1,228 stocks a share price under $10. That’s 42% of the index. At the market’s 2002 lows, there were significantly less stocks trading below $10/share – just 884. (Bespoke)”

The Wall Street Journal: Obama likely to pick Fed’s Geithner for Treasury
“President-elect Barack Obama is expected to nominate as Treasury Secretary Timothy Geithner, the president of the Federal Reserve Bank of New York and a figure who has been deeply involved in tackling the financial crisis.

“Mr. Geithner, 47 years old, would be one of the youngest-ever US Treasury secretaries. His nomination would come as Wall Street is being challenged by the financial crisis and a Washington power vacuum, and as the world’s debt markets show fresh signs of falling into deeper problems.

“Mr. Obama is expected to introduce his entire economic team on Monday, according to people familiar with the matter. The president-elect has been under pressure to speed up his transition as stock markets this past week fell to lows not seen since the late 1990s.

“Mr. Geithner served as a Treasury attaché in Japan in the 1990s and later at the International Monetary Fund. He was a protégé of former Treasury Secretaries Lawrence Summers and Robert Rubin. Mr. Summers, who was also a potential candidate, instead is expected to take a position within the White House as an economic adviser.

“Mr. Geithner has spent most of his career managing government responses to financial crises, from the 1990s bailouts of Mexico, Indonesia and Korea, to the debt-market meltdown that has brought Wall Street to its knees this year.

“Mr. Geithner (pronounced GYTE-ner) pushed for earlier intervention in the financial markets to stem the financial crisis, and looks likely to continue that activist approach in his new job. Among his first priorities could be a large fiscal-stimulus package.

“Unlike previous picks for Treasury secretary, who hailed from Wall Street, industry or the Senate, Mr. Geithner has been a technocrat most of his career.”

Financial Times: US economy chiefs say policies bear fruit
“The cost of insuring top quality US companies against default hit a record high on Tuesday even as Hank Paulson and Ben Bernanke told Congress that their radical policy actions to ease the credit crisis were starting to bear fruit.

“‘We have turned the corner in terms of stabilising the system and preventing collapse,’ said Mr Paulson, Treasury secretary. He called for patience, saying: ‘There is a lot of work that still needs to be done in terms of recovery of the financial system.’

“Mr Bernanke said there were ‘some signs that credit markets, while still quite strained, are improving’.

“However, the Federal Reserve chairman noted that ‘overall credit conditions are still far from normal, with risk spreads remaining very elevated’.

“On Tuesday, the CDX index that measures the cost of insuring investment grade companies against default closed at a record high on mounting concern about the global economy, and there were fresh signs of dislocation in the swaps market.

“Meanwhile, indices that measure the value of securities backed by residential and commercial property loans – which have plunged since Mr Paulson abandoned his plan to buy toxic assets last week – continued to plumb new depths.”

The Wall Street: Paulson, Summers, Rubin debate crisis
“Current Treasury Secretary Henry Paulson and predecessors Lawrence Summers and Robert Rubin locked horns over the best way to get the US economy back on track.”

Bespoke: Paulson trying to rewrite his own history
“Treasury Secretary Henry Paulson spoke at the Reagan Library this afternoon, and judging by the speech, it appears as though Mr. Paulson is embarking on a PR campaign to rewrite the history of his handling of the credit crisis. One line that stood out was when he said: ‘By pro-actively addressing the problems we saw coming …’

“Judging by excerpts of prior comments the Treasury Secretary made during 2007, if Mr. Paulson saw the problems coming, he wasn’t telling anybody.

“Marketwatch 3/13/07: Paulson also said the fallout in subprime mortgages is ‘going to be painful to some lenders, but it is largely contained.’

“Forbes 7/27/07: Appearing on CNBC with other members of the Bush administration’s economic team, he again said mortgage industry problems would be ‘largely contained.’

“Boston.com 8/1/07: Paulson added that he did not see anything that caused him to reconsider his view that the economic damage from the housing correction was ‘largely contained.’

“Another classic line from today was, ‘As I assess our current situation, I believe we have taken the necessary steps to prevent a financial collapse.’ Mr. Paulson, what is it going to take for you to consider this a financial collapse?

“Given that the extent of the credit crisis was underestimated by almost everyone, you can give Paulson somewhat of a pass for missing it. But to try and rewrite history through speeches even while the credit crisis is still playing out is inexcusable.”

Financial Times: Congress reaches an impasse on car bailout
“The US Congress is unable to approve a new emergency loan to the country’s troubled car sector, Democratic leaders said on Thursday.

“Industry chiefs’ pleas for aid appeared to backfire after two days of hearings on Capitol Hill. News of the impasse over one of the hardest-hit sectors of the US economy came as President George W. Bush agreed to extend unemployment benefits after US weekly jobless claims hit a 16-year high.

“Harry Reid, Senate majority leader, and Nancy Pelosi, speaker of the House of Representatives, said there were not enough votes to pass a $25 billion loan for Detroit that Democrats had advocated. They said car companies had to be more specific about restructuring.

“The pair gave the big three carmakers – General Motors, Ford and Chrysler – until December 2 to submit a ‘viable’ recovery plan, with the prospect of convening hearings immediately afterwards and possible congressional votes a week after that.

“The announcement came in spite of last-minute efforts by six Democratic and Republican senators from car-producing states to reach a deal on a bridging loan.”

ABC News: Auto bailout – would be better to burn the money
“Congress is debating cutting the Big Three Autos a check … something to tide them over through these tough times. General Motors is bleeding money … some 2 billion dollars a day. Bail them out or let them go bankrupt? That’s the billion dollar question. And its billions of your money.

“One side says give them money – they’re too big to fail, too many jobs will be lost, the American economy will be hit hard, they need time to get fuel efficient cars to the market.

“The flip side – let them fail, they brought this on themselves, pouring 25 billion into these failed models is a waste, bankruptcy protections will let them out of their incredibly expensive labor contracts.

“… David Yermack from NYU Stern Business School chimed in: ‘The implications of this story for Washington policy makers are obvious. Investing in the major auto companies today would be throwing good money after bad. Many are suggesting that $25 billion of public money be immediately injected into the auto business in order to buy time for an even larger bailout to be organized. We would do better to set this money on fire rather than using it to keep these dying firms on life support, setting them up for even more money-losing investments in the future.'”

Paul Kedrosky (Infectious Greed): The auto bankruptcy teeter-totter
“GM, for its part, isn’t taking this lying down. It has posted a video on YouTube explaining – okay, propagandizing – the implications of letting it die. Watch it to see how the straight-to-consumer “Save us!” game is played.”

CNBC: Financial crisis tab already in the trillions
“Given the speed at which the federal government is throwing money at the financial crisis, the average taxpayer, never mind member of Congress, might not be faulted for losing track.

“CNBC, however, has been paying very close attention and keeping a running tally of actual spending as well as the commitments involved.

“Try $4.28 trillion dollars. Not only is it a astronomical amount of money, it’s a complicated cocktail of budgeted dollars, actual spending, guarantees, loans, swaps and other market mechanisms by the Federal Reserve, the Treasury and other offices of government taken over roughly the last year, based on government data and new releases. Strictly speaking, not every cent is directed as a result of what’s called the financial crisis, but it arguably related to it.”

“‘Debt or TARP capital is not true capital. Long-term debt financing is not the solution. Only injections of true tangible common equity will solve the current crisis,’ he said.

“Currently, the US financial system has $37 trillion of debt outstanding, he noted.

“Combined, these eight companies have roughly $12.2 trillion of assets and only $406 billion of tangible common capital, or just 3.4%, the analyst said.

“Miller said these institutions need somewhere between $1 trillion and $1.2 trillion of capital to put their balance sheets back on solid ground and begin to extend credit again, given their dependence on short-term funding and the illiquid nature of their asset bases.”

Mr Mortgage: The great mortgage modification pump
“Reworking loans to make ‘payments affordable’ without permanently reducing principal balances is the worst possible thing that can be done because it ensures the housing and foreclosure crisis will be with us for a long time. If these programs are widely accepted, housing is a dead asset class indefinitely …

“This style of modification does not sit well with owners of mortgage securities either, which make up the bulk of distressed mortgages. This is because deferred interest, 40-year terms and interest only teaser periods, greatly reduces the cash flows and lengthens the duration of the security.”

Credit Suisse: More fiscal action needed to ease crisis
“The US, Europe and Japan are in significant recession, says Giles Keating, Head of Global Research at Credit Suisse. He explains how the financial crisis is evolving and why capital injections are needed.”

Reuters: Fed’s Hoening – Fed has done “as much as it can”
“Kansas City Federal Reserve President Thomas Hoenig said on Monday the US central bank has done what it can to buffer the economy through a downturn, and a painful process of readjustment is likely ahead.

“‘The Fed has done about as much as it can do,’ he said in an interview on PBS’s Nightly Business Report. Interest rates are already extremely low, he noted, according to a transcript of the program.

“‘We might put it out there, but banks are not able to, given their own capital constraints, able to lend as aggressively,’ he added.

“Hoenig said he was surprised at how quickly economic activity has slowed, but that a sharp reversal of consumption was clearly a key development.

“‘The consumer factor was a major part of the strong slowdown and the actual entering into the recession,’ he said.

“‘Part of it is working through the deleveraging,’ he said. ‘I don’t know of any painless way to rebalance your economy, you have to go through this adjustment, and we will get through it, but it’s not going to be without consequence,’ he added.”

Bloomberg: NABE’s Varvares says US recession to extend into 2009
“Chris Varvares, president of Macroeconomic Advisers LLC and president of the National Association for Business Economics, talks with Bloomberg about the results of NABE’s survey of business economists.”

Clusterstock: Roubini – How are we screwed? Let us count the ways
“Nouriel Roubini weighs in with another treatise of doom, this time focused on consumer spending. He lists 20 reasons consumer spending is headed to hell in a handbasket, taking the economy down with it. We’re short on Prozac, so we’ll summarize only a handful here, and we’ll let Nouriel take it away:

“Today’s news about October retail sales (-2.8% relative to the previous month and now down in real terms for five months in a row) confirm what this forum has been arguing for a while, i.e. that the US has entered its most severe consumer-led recession in decades. At this rate of free fall in consumption real GDP growth could be a whopping 5% negative or even worse in Q4 of 2008. And this is not a temporary phenomenon as almost all of the fundamentals driving consumption are heading south on a persistent and structural basis …”

Asha Bangalore (Northern Trust): What is the Fed’s next move?
“The minutes of the October 28 to 29 FOMC meeting were published this afternoon [Wednesday]. The main thrust of these minutes is that economic growth is the topmost concern. The minutes noted that ‘members also saw the substantial downside risks to growth as supporting a relatively large policy move at this meeting, though even after today’s 50 basis point action, the Committee judged that downside risks to growth would remain. Members anticipated that economic data over the upcoming intermeeting period would show significant weakness in economic activity, and some suggested that additional policy easing could well be appropriate at future meetings.’

“The target rate was lowered to 1.0% on October 29, with the effective rate trading between 22 bps and 37 bps since then. Is there a benefit to lowering the Federal funds rate? A lower Federal funds rate, as suggested in the minutes of the October 28-29 meeting, would only accomplish validating the already low effective Federal funds rate. It is possible the Fed could cut the Federal funds rate and abandon attempting to manage the effective rate such that it trades close to the target rate. It appears that the Fed may be considering the possibility of a zero federal funds eventually, if economic conditions warrant it.”

Bloomberg: Fed to cut rates to zero on deflation risk, JPMorgan predicts
“The US Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase.

“The Fed will lower borrowing costs by 50 basis points at each of the next two policy meetings on December 16 and January 28, JPMorgan economist Michael Feroli wrote in a note to investors yesterday. The central bank will hold rates at zero for the rest of 2009 to prevent prices from spiraling down as companies cut jobs and banks reduce lending, stifling spending, Feroli said.

“The Fed may not be the only central bank to begin offering free money to jolt life into their recessionary economies and keep prices rising as the 15-month credit crisis deepens. The Bank of Japan cut its benchmark rate to 0.3% last month, and the European Central Bank has signaled it’s ready to lower rates further after two reductions in the past six weeks.

“‘Taking the target rate to zero percent would not be costless for the Fed,’ Feroli said. Public confidence may drop ‘if there is a perception that the Fed has run out of ammo’.”

Asha Bangalore (Northern Trust): Leading index points to further weakening of economy
“The Conference Board’s Index of Leading Economic Indicators (LEI) dropped 0.8% in October after a revised 0.1% increase in September. The LEI has dropped in four of the last six months. On a year-to-year basis, the LEI has dropped 3.5%, the largest monthly decline for the current cycle.

“The LEI has sent a reliable warning of weakening economic conditions for all recessions since 1960, with the exception of the 1967 dip (the economy was weak in this period but it was not a recession).”

Asha Bangalore (Northern Trust): Industrial production is significantly weak
“The headline industrial production index rose 1.3% in October, after a 3.7% drop in September. The September estimate now shows a larger drop than the original estimate of a 2.8% decline due to revised estimates of the impact of Hurricanes Gustav and Ike on the chemical industry. According to the Fed, excluding the special factors of hurricanes and Boeing strike, industrial production dropped 2/3 percent in both September and October.”

Asha Bangalore (Northern Trust): Decline in housing starts stress persistence of housing turmoil
“Total housing starts dropped 4.5% to an annual rate of 791,000 in October, reflecting a decline in starts of both multi-family and single-family units. These numbers along with the record low of the Housing Market Index of the National Association of Home Builders in November imply that the bottom of housing starts is not here yet.”

Asha Bangalore (Northern Trust): Housing market update – grim news bolsters Sheila Bair’s plan to stem the crisis
“The grim housing market news continues to support opinions that the mortgage problem is the key to a resolution of the current financial market crisis. The crux of the issue is that falling home prices, foreclosures, and rising inventories need to be replaced by more stable conditions for the economy to turnaround. The National Association of Home Builders reported in the November survey that the Housing Market Index fell to 9.0 from 14.0 in October to establish a new record.”

Asha Bangalore (Northern Trust): Consumer Price Index plunges
“Today the BLS reported that the Consumer Price Index (CPI) fell by 1.0% both seasonally adjusted as well as unadjusted. On an unadjusted basis, this was the largest monthly decline in the CPI since January 1938.”

BCA Research: Heading for deflation?
“A deflation scare will grip the developed world over the next 12 to 24 months.

“Our research on past real estate bear markets and subsequent banking sector stress (throughout Europe, the US and Japan) highlights that these episodes always lead to a recession, followed by a multi-year period of sub-par growth (i.e. negative output gap). In turn, excess supply helps dramatically drive down core CPI inflation in the years that follow. Granted, it could be argued that the previous episodes occurred during a period of strong structural disinflationary trends, thereby amplifying the magnitude and duration of the decline in price pressures.

“Nonetheless, core CPI inflation is likely to drop sharply throughout the G7 over the next 12 to 24 months, to lows at least comparable to the 2003 deflation scare. In turn, it is likely that the US prints very low positive or even mildly negative headline CPI numbers, given the drag resulting from the recent plunge in food and energy prices.

“Headline inflation is less likely to turn negative in Europe given the rigidity of the price structure but a deflation scare similar to the US earlier this decade is likely. The implication is that policymakers will continue to ease aggressively and then stay on hold for an extended period, benefiting our long duration call. “While the longer-term consequences of such actions may be inflationary, government bond yields will adjust lower in the near term.”

Bloomberg: Bond-market yields signal deflation worldwide
“Bonds worldwide are showing that investors are betting that slumping economic growth will lead to deflation in every major economy. Britain’s five-year breakeven rate went negative Tuesday for the first time since Bloomberg records began in 1996.”

Financial Times: In a weird world, yields on Tips point to deflation
“Would you believe that we shall actually have significant deflation in the US next year? And the year after that? And flat consumer prices for the year following? That’s happened only once in a developed country since the 1930s – when Japan recorded a negative 1.6% consumer price index for 2002.

“Yet, if you believe the yields on US Treasury inflation protected bonds, or Tips, we shall have a 2.2% fall in prices in 2009, a 2.5% decline in 2010 and only flat prices in 2011. If that turns out to be true, the real interest rate burden on even the highest-rated borrowers will be extremely hard to bear.”

John Davies (WestLB): Buy German bunds
“The 10-year German Bund yield could fall to a record-equalling 3 per cent in the months to come in response to worries about the eurozone economy, believes John Davies, bond analyst at WestLB.

“‘Given the contracting economy and mounting threat of deflation, we now expect the European Central Bank to cut rates to 1.5% by the summer [from 3.25% now], which is lower than the market expects,’ he says.

“Mr Davies notes that the rapid steepening of the spread between two-year and 10-year German yields, which started in September, has slowed as the market moves to price in rates of 2% by the spring.

“While the steepening will primarily be driven by moves at the short end of the curve, long-end yields will fall as recession fears overshadow a jump in new issuance, Mr Davies says.

“‘We expect the 10-year yield to fall from 3.6% to 3.25% within the next three-to-six months, and even test the 3% record low set in September 2005. It is only the rise in supply next year that stops us projecting a sub-3% yield.'”

Bloomberg: China passes Japan as biggest US Treasuries holder
“China surpassed Japan in September to become the biggest foreign holder of US Treasuries, as foreign investors sought the relative safety of government debt as stocks plunged 9.1% that month.

“Total net purchases of long-term equities, notes and bonds increased a net $66.2 billion in September from $21 billion the previous month, the Treasury said today in Washington. Including short-term securities such as stock swaps, foreigners bought a net $143.4 billion, compared with net buying of $21.4 billion the month before.

“China led all foreign official investors in September by posting a net increase in US Treasuries for the sixth month in the past seven, bringing its total ownership close to $600 billion. Japan was a net seller of Treasuries for the fourth month in the past six.

“‘The details of the report paint a much more positive picture of cross-border investments than expected,’ said Michael Woolfolk, a senior currency strategist at Bank of New York Mellon Corp. ‘China, along with others, is showing more demand than anticipated for US assets.'”

Source: John Brinsley and Rebecca Christie, Bloomberg, November 18, 2008.

Bespoke: High yield spreads – no slowdown in sight
“If you’re looking for signs of stabilization in the credit markets, the high yield market is not a good place to start. Based on data from Merrill Lynch, high yield bonds are yielding nearly 1,800 basis points more than comparable Treasuries. In the last month alone, spreads have risen by more than 200 basis points, and since bottoming in the Summer of 2007 at 241 basis points, they are up 645%. To put this in perspective, with the 10-year US Treasury now yielding 3.4%, a high-yield borrower would need to pay roughly 21.4% per year to take out a ten-year loan. With terms like these, who needs loan sharks?”

Bespoke: Financial weapons of mass destruction aimed at Omaha
“Warren Buffett is credited with coining the phrase ‘financial weapons of mass destruction’ with respect to derivatives. However, after some big unrealized losses on index options that Berkshire has written in the last couple of years, it now appears as though the derivative market is taking aim at Omaha. Over the last eight days, the cost to insure debt of Berkshire Hathaway has risen to 475 basis points per year. To put this into perspective, Morgan Stanley’s credit default swaps are currently trading at 456 basis points, and that is the highest of the big global banks and brokers. Berkshire Hathaway has long been considered one of the safest of the safest financial companies, but if Black October 2008 has taught us anything, it’s that nothing is safe.”

Bespoke: S&P 500 200-day moving average spread at -32%
“Multiple market pundits have recently mentioned that the S&P 500 is trading the furthest below its 200-day moving average since the Great Depression. Below we have plotted the 200-day spread indicator going back to 1927. The index is currently trading 32% below its 200-day moving average, which is indeed the most negative spread since 1937. While the spread can remain negative for quite some time, the reaction to the upside has been extreme once the market turns. In the 1930s, and even following the big declines in the 70s, 80s, and early 2000s, the spread turned violently positive in the months following the ultimate low in the 200-day spread. Unfortunately, nobody knows when that low will be.”

Barron’s: Reversal of fortunes between stocks and bonds
“… the dividend yield on the Standard & Poor’s 500 stock index touched 3.57% at 1:13 PM Eastern time [on Tuesday], exceeding the 3.54% yield on the benchmark Treasury 10-year note, according to Bloomberg News. That’s something that hadn’t happened since 1958.

“I was aware that there was a time when equities provided more income than bonds, but that belonged to a long-gone era. That was a time I knew of only from old movies, yellowed newspaper clippings and stacks of old Life magazines. It was when gentlemen wore suits and fedoras, not just to work but even to the ballpark; when the Dodgers played in Brooklyn; a bygone era already a half century ago.

“To contemporary market observers, it’s more than nostalgia. For the S&P 500 to yield more than Treasuries suggests the market is very cheap by historical standards, says Jack Ablin, portfolio strategist for Harris Private Bank. ‘Dividend yield, like price-to-sales, is one of those persistent metrics. We can all quibble about earnings, but dividends, particularly those of the entire S&P 500, are remarkably consistent,’ he adds.

“‘You can fake earnings through account hanky-panky, but you cannot fake dividends,’ agrees Barry Ritholtz, chief executive of Fusion IQ. So after a 47% drop, stocks look relatively cheap for the first time in a long time, he adds.

“Scott Minerd, chief investment officer for Guggenheim Partners, calls the drop in Treasury yields below the S&P 500 dividend yield a ‘straw in the wind’ that the stock market may be bottoming. Still, he thinks the market is signaling that dividend cuts are in the offing, but this recessionary trend also will push Treasury yields still lower.”

Frank Holmes (US Global Investors): An emotionally impaired market
“Global equities are now trading on their lowest valuations since the early 1980s. History says we should expect stock prices to turn up before earnings do. A recovery in earnings, when it happens, has previously been a robust second leg for more significant price appreciation. The second leg will take place when the earnings recession ends and profits begin to recover. Investment research based on historical patterns by Citigroup suggests the second leg is about 12 months away. With this in mind, we’re nibbling on stocks we believe are undervalued based on fundamental screens and have been hit the hardest as candidates for price appreciation.

“Weak earnings and expectations of more bad news to come have weighed heavily on stock prices. The global equity market trades on 10 times trailing earnings and over 15 times expected trough earnings. The 40-year average global price-to-earnings ratio is 17 times. Citigroup’s research demonstrates that the global equity market is extremely undervalued, but valuations could continue to fall through year end.

“We believe the market and economy are now being emotionally impaired due to the cascading negative news by unbalanced media. Today [Friday] is the first day this week without negative grandstanding politicians on TV and the market was up. Stocks are so oversold and markets, as we have commented in the past, are due for a substantial rally. We believe the market is looking for certainty that President-elect Obama and his team are not going to raise taxes in this economic environment. If the new administration reverses course and denounces tax hikes for two years and proposes a budget to rebuild our infrastructure, then this week could have been the bottom for the market.”

Bespoke: Trailing 12-month P/E ratios are low
“The S&P 500 Financial, Consumer Discretionary, and Telecom sectors currently have negative P/E ratios, which makes the overall index’s P/E high at 18.41. Sectors whose P/Es aren’t negative have very low trailing P/Es versus historical readings. The Energy sector currently has the lowest P/E at 6.55. The second lowest is Materials at 9.14, followed closely by Industrials at 9.44. And the Technology sector, which usually has a relatively high P/E, currently has a P/E of just 12.49.”

“‘We see a consumer boom in all of those countries,’ Mobius, who oversaw more than $24 billion in emerging-market stocks on September 30 as executive chairman at Templeton Asset Management, said in a Bloomberg Television interview from Johannesburg. ‘Per-capita income is growing at a very rapid pace in these countries.’

“China announced a $586 billion stimulus plan on November 9 after its gross domestic product grew 9% in the third quarter, the slowest pace in five years. India’s central bank estimates growth will slow to 7.5% this year and next, from an annual average of 8.9% in the past four years. Emerging markets will expand at an average of 5% in 2009, compared with 1% in developed countries, Mobius forecast on October 21.

“The global economic downturn may not be as long or severe as expected because of the coordinated fiscal and monetary stimulus put forth by policy makers worldwide, the 72-year-old investor said today.

“The slowdown ‘will be rather short-lived and, of course, the markets will anticipate this’, Singapore-based Mobius said. ‘There will be some deceleration, but these are still fast- growing countries.'”

David Powell (Bank of America): Is the dollar’s recent rally coming to an end?
“David Powell, currency strategist at Bank of America, believes the dollar has lost several important sources of support.

“The global shortage of dollar liquidity – one of the primary reasons for the US currency’s strength as the financial crisis escalated in September – has been sharply reduced by the extraordinary measures introduced by central banks to ease money market stress, he says.

“Furthermore, the repatriation of the dollar, which prevented its retracement as tensions in the wholesale funding markets were reduced, may no longer provide the currency with much support moving forward. Private sector flow data indicate the repatriation of foreign investments to the US is slowing sharply, Mr Powell says.

“‘A third factor behind the resilience of the dollar seems to have been the steady return offered by longer-dated US Treasuries, when compared with the sharp drop in German Bund yields. However, the fall in the euro against the dollar appears excessive even when compared to drop in the 10-year Bund-Treasury yield spread.

“‘In addition, a dollar retracement is likely to gain momentum from the pattern of seasonal weakness normally seen in December. As such, we affirm our year-end euro/dollar forecast of $1.38 and outlook for a return to $1.44 by the first quarter of 2009 before the pair resumes a more gradual sell-off.'”

Financial Times: Jim Rogers – the dollar is a flawed currency
The following is an excerpt from an online interview with Jim Rogers.

“FT: It’s a year since we last interviewed you. You were aggressively bearish about the dollar, but you thought there would probably be a rebound and you would take that as an opportunity to further get out of the dollar. Have you made a further exit from the dollar?

“JR: Not yet, no. And the reason I haven’t is because we’re in a period of forced liquidation of everything. We’ve only had eight or nine periods like this in the past 150 years, where everybody has to reverse their positions on everything. There is a gigantic short position in the dollar and they’re all having to cover as they reverse their positions, so this rout is going to go on much further than I would have expected, to my delight, because then I’ll get to sell at higher prices. I don’t know whether I’ll get out this month or this year even, maybe next year, but I do plan to get out of the rest of my US dollars, because this is an artificial rally caused purely by short covering.

“FT: How will you tell when that deleveraging is finally over?

“JR: I’m sure I won’t get it right, but I do hope that when there’s a lot of euphoria about the dollar and everybody’s saying, well, see, there’s no problem with the dollar … I hope I’m smart enough to recognise it and finally get out of the dollar, because it is a flawed and maybe, even, doomed currency.

“FT: Do you see the sell-offs we’ve seen in commodities as a drastic correction?

“JR: Well, we’re in a period of forced liquidation of all assets … we’re getting the business cycle effect on demand right now, certainly, but unless the world’s in perpetual economic decline, commodities are the only thing going to come out of this okay.

“FT: Does this mean you’re actually buying back into commodities at the moment, or is this an area you’re standing clear of?

“JR: No, no. In October when I started covering my shorts in the US stock market, I started buying Chinese shares, Taiwan shares, I started buying commodities again. No, no, I’ve added to those positions.

“FT: What’s your strategy towards emerging market stocks?

“JR: My hope is that I’m smart enough and brave enough at some point along the line to buy some of them back. But I’m not even thinking about it right now … The world’s financial situation is in a mess, and there are a lot of people who have to liquidate. I mean, we must have had 30,000 MBAs flying around the world looking for emerging markets. All of that money has got to come home.

“FT: How do you think the world should go about redesigning the regulatory system, and are you worried that we’re going to end up with a swing towards over-regulation?

“JR: Well, we probably will, The problem is that people like Alan Greenspan would never let the market work … For 15 years, under Greenspan, and now Bernanke, they would not let the market work. Had they let Long-Term Capital Management fail back in 1998, we wouldn’t have these problems now, I assure you. Lehman Brothers would have been smashed. Goldman Sachs, Bear Stearns, would have been smashed. We wouldn’t have these problems now. That only happened because every time they turned around they propped these guys up, gave them more money, and that’s why we have the problem … But now, of course, they’re going to blame it on other people and cause more regulations.

“FT: You’re arguing we need to allow some more big institutions to fail?

“JR: One failed. Why didn’t they let Fannie Mae and Freddie Mac? I mean, I was short Fannie Mae, and they should have let it fail, go to zero. AIG, they should have let it fail, they should have let all of these guys fail, and we would clean out the system … What they’re doing is they’re taking the assets away from the competent people, giving them to the incompetent people and saying to the incompetent: ‘Okay, now you can compete with the competent people, with their money.’ I mean this is terrible economics. This is outrageous economics.”

Bloomberg: China should buy gold for reserves, Association says
“China, the second-biggest overseas holder of US Treasuries, should increase its bullion holding to diversify its reserves because the dollar may decline, the country’s gold association said.

“‘China should have at least several thousand tons of gold in its reserves, five to six times the officially announced 600 tons,’ Hou Huimin, vice chairman of the China Gold Association said from Beijing. The group represents producers, traders and retailers.

“The US budget deficit climbed to a record in October, and some investors are betting the dollar may weaken as the Treasury would need to sell more debt to finance its $700 billion financial-rescue package. Gold has tumbled 29% from its March record.

“‘There’s no doubt that gold would be attractive, as US debt is likely to swell,’ said Kenichiro Ikezawa, who oversees about $3 billion as a fund manager at Daiwa SB Investments in Tokyo. ‘In the long term, both the dollar and Treasuries will probably weaken. It’s possible that China will buy more gold, though the country is likely to do so gradually.'”

Reuters: Iran switches reserves to gold
“Iran has converted financial reserves into gold to avoid future problems, an adviser to President Mahmoud Ahmadinejad said in comments published on Saturday, after the price of oil fell more than 60% from a peak in July.

“Iran, the world’s fourth-largest oil producer, is under UN and US sanctions over its disputed nuclear programme and is now also facing declining revenue from its oil exports after crude prices tumbled.

“‘With the plans of the presidency … the country’s money reserves were changed into gold so that we wouldn’t be faced with many problems in the future,’ presidential adviser Mojtaba Samareh-Hashemi was quoted as saying by business daily Poul.

“Iranian officials in July denied reports that Iranian banks were moving funds from Europe, with one report suggesting as much as $75 billion had been withdrawn and converted into gold or placed in Asian banks, because of a threat of tightening sanctions.”

The New York Post: Global run on gold coins
“There’s a worldwide run on gold coins. Even as the price of the precious metal itself comes under pressure along with commodities like oil and copper, people around the world are demanding so many of the valuable coins that government mints are having difficulty filling orders.

“A spokesperson for the US Mint tells me that gold coins in this country, for the past month, ‘are being allocated because of an increased demand’.

“And the price that the government charges coin dealers has recently been increased by as much as 10% for a 10-ounce coin.

“And even when gold coins are available, dealers report that customers are paying a bigger premium than they would have just a few months ago.

“In one sense, the attraction for gold coins isn’t surprising. Since ancient times, gold has been considered the safest investment to hold in times of uncertainty.

“With fears of future inflation rising and concern about the value of paper currency and government-debt increasing with each new recovery plan announced in Washington and in foreign capitals, the desire to hold gold grows.

“That part makes perfect sense. But there’s another more puzzling aspect to the recent gold rush. Even as the demand for gold coins such as the Canadian Maple Leaf or the Krugerrand of South Africa has grown, the market price of the precious metal itself is off its highs.

“Bill Murphy, chairman of the Gold Anti-Trust Action Committee, says the price of spot gold is even more perplexing given the demand for coins and the fact that central banks in Europe have stopped selling gold into the open market.

“‘Gold should be moving up,’ Murphy says. ‘How could there be such a dichotomy between the historic high premium for coins all over the world and the low Comex price?’

“His answer? ‘Today the public is buying gold like crazy, but the US government and the banks that hold bullion are intentionally keeping the price down.'”

James Pressler (Northern Trust): Japan enters first recession in 7 years
“Today’s indicators out of Japan confirmed what we had expected – that Japan is in recession, though the consensus believed there were enough one-offs to growth to keep the headline figure on the positive side of zero. Real GDP contracted by 0.1% from the previous quarter after a sharper fall of 0.9% in Q2 (originally -0.7%), with Q3 consumption rising by 0.3% after a fall of 0.6%. True, there were factors that perked up private consumption, but they were not enough to overcome a weak net exports figure that will only get worse in the coming quarters.”